Tiered partnerships are popular investment vehicles that generally allow for a good deal of flexibility, which is in and of itself a fully nontax consideration. Further, certain tax benefits add to the structure’s attractiveness, such as a single layer of tax and favorable capital gains treatment for capital transactions. However, as part of the Obama administration’s tax reform agenda, these structures could be subject to ordinary income tax treatment on many forms of revenue that had previously enjoyed a lower capital gain tax rate.

First, as part of the Patient Protection and Affordable Care Act (PPACA), P.L. 111-148 (as amended by the Health Care and Education Reconciliation Act of 2010, P.L. 111-152), the net investment income tax was created (new Sec. 1411) effective Jan. 1, 2013. The tax rate is 3.8%, and the proposed regulations (REG-130507-11) cast a very large net, capturing most forms of income. Most multitier partnership investments appear to be sheltered from the net investment income tax as long as the activity is not “passive.” However, for those involved in trading in financial instruments or commodities, these activities appear to be subject to the net investment income tax, regardless of whether that activity is active or passive for the taxpayer.

Second, proposed changes to the tax treatment of carried interests are still being debated as part of overall tax reform. Several similar proposals have been made in recent years. They generally would treat all “carried interest” income related to an investment services partnership interest (ISPI) as ordinary income, including any gain derived from the sale of the interest (see the American Jobs Act of 2011, H.R. 12, S. 1549; the American Jobs and Closing Tax Loopholes Act of 2010, H.R. 4213; H.R. 1935 (2009); and Levun, “Planning Considerations in Anticipation of the Potential Carried Interest Legislation,” Partnership Tax Watch Newsletter (October 2010)). These rules rely on several new concepts, one of which is the “specified asset.” The issue with multitier partnership structures is that a partnership interest, for purposes of the carried interest proposals, would itself be considered a specified asset. This broad definition of a specified asset would insert an ISPI in many multitier partnership structures involved in businesses not originally targeted by the proposals. In these structures, any carried interest income would suddenly become subject to ordinary income tax rates.

The Net Investment IncomeTax Rules andTiered Partnerships

Generally, the net investment income tax targets income derived from two types of activity: (1) passive activity and (2) income from the trade or business of a trader trading in financial instruments or commodities (Prop. Regs. Sec. 1411-5(a)). These activities create net investment income (Prop. Regs. Sec. 1411-4(a)).

Passive activity: In the case of an individual, estate, or trust that owns an interest in a trade or business through one or more passthrough entities, the regulations state that the determination of whether an activity is passive in the hands of the taxpayer is generally made at the “owner” level (Prop. Regs. Sec. 1411-4(b)(2)).

The regulations attempt to illustrate this with a few examples (Prop. Regs. Sec. 1411-4(b)(3)), and the first one raises an interesting question. In this example, an individual owns an interest in an upper-tier partnership (UTP), which is not engaged in a trade or business. Would the dividends that flow up to the individual through his ownership in the UTP be considered passive income for purposes of the net investment income tax? The answer in the proposed regulations is “yes.”

In other words, the “passive” quality of a lower-tier partnership’s (LTP’s) trade or business flows up to the owner of the UTP. The owner therefore is solely the individual, and the UTP is essentially ignored. Consider then the opposite fact pattern, not addressed in the regulations:

Example: OpCo (the LTP) is owned by a fund (the UTP). The UTP is owned 80% by investors and 20% by managing partners of the LTP.

If the rules are applied as they are described in the regulations, it would appear that the “active” quality of the LTP’s activities would not be “active” to the UTPor the managing partners. The determination would have to be made on an owner-by-owner basis at the managing partner level (the owner level). The question then is, does the intermediary fund in some way “taint” the income for the managers? The answer may be that this was not the intent of the law and that the managers’ activity with regard to the LTP should be considered. In other words, the fund should be ignored. This remains to be confirmed by the IRS.

Note however that this does not appear to be the case where the activity is trading in financial securities and commodities. Here, even though a manager is materially participating in the trade or business, it does not “cleanse the taint” because that income is “toxic” at its source under the net investment income tax rules.

Trading in Financial Instruments or Commodities

It appears that the fundamental dichotomy of passive versus trade or business is no longer useful for purposes of the net investment income tax when the business is investing. The passive loss rules, regulations, and case law under Sec. 469 relate almost exclusively to whether an activity is active or passive. Prop. Regs. Sec. 1411-4(c)(2) specifically carves out “trading in financial instruments or commodities” as an activity subject to the tax. What this seems to mean, for purposes of the net investment income tax, is that regardless of whether the activity (trading in financial instruments and commodities) is active or passive, it generates “investment income” and is subject to the 3.8% tax. Furthermore, this characterization reaches up the chain in tiered situations.

Consider a typical hedge fund situation where the manager fund is the UTP and the fund itself is the LTP. The fund itself is trading, and the income it generates from the activity is necessarily toxic. Further, even though the manager fund and the managers themselves are materially participating in the fund’s business, they appear to still be subject to the net investment income tax because they are participating in an activity that is specifically targeted by the net investment income tax rules.

Finally, even if the manager fund is an S corporation, the toxicity appears to pass through to the managers because the S corporation is itself considered to be “trading in financial instruments or commodities” and it does not appear to get any relief from its legal form.

Note that further guidance from the IRS regarding the net investment income tax rules is expected.

New Carried Interest Rules and the Creation of “Investment Services Partnership Interests”

A carried interest is typically structured for tax purposes as an allocation of a portion of the partnership’s profits. In contrast, a capital interest is an interest in partnership assets that are immediately distributable to a partner upon his or her withdrawal from the partnership or upon the liquidation of the partnership (see Regs. Secs. 1.704-1(e)(1)(v) and 1.721-1(b)(1); Rev. Proc. 2001-43, §2, clarifying Rev. Proc. 93-27, §2.01). This preserves the underlying tax characteristics of the partnership’s income and gain for the recipient of the carried interest, and “preservation of the capital gains character of incentive compensation in the hands of the [partner] is a critical structuring feature” (Schell, Private Equity Funds: Business Structure and Operations §2.02 (Law Journal Press 2011)).

However, legislation introduced in recent years (and proposed again by President Barack Obama in his FY 2014 budget) would tax all carried interest income (above and beyond the income generated by the capital interest) at ordinary income tax rates. Generally, the various proposed bills would introduce a new Sec. 710, which would treat all or part of the income allocated to the carried interest holder (e.g., gain on sale of the partnership’s specified assets) as ordinary income and would recharacterize as ordinary income all or a portion of the gain realized by a carried interest holder on the transfer of the interest.

Proposed Sec. 710 would apply to an “investment services partnership interest,” which is defined (in the American Jobs and Closing Tax Loopholes Act of 2010 version) as—

[A]ny interest in a partnership which is held (directly or indirectly) by any person if it was reasonably expected (at the time that such person acquired such interest) that such person (or any person related to such person) would provide (directly or indirectly) a substantial quantity of any of the following services with respect to assets held (directly or, to the extent provided by the Secretary, indirectly) by the partnership:

(A) Advising as to the advisability of investing in, purchasing, or selling any specified asset.

(B) Managing, acquiring, or disposing of any specified asset.

(C) Arranging financing with respect to acquiring specified assets.

(D) Any activity in support of any service described in subparagraphs (A) through (C).

For tiered partnerships, the issue is that an interest in a partnership is itself considered a specified asset. This implies that owning an interest in a UTP that provides services to an LTP is susceptible to ISPI characterization, even though the LTP does not, itself, own specified assets.

In other words, where a partner in the UTP provides services to the LTP, the UTP’s interest in the LTP will qualify as an ISPI. Further, the ISPI rules would affect not only the managing partner’s returns but those of all of the UTP’s partners.

It appears that this legislation was aimed at the fund management and real estate industries, and this result may not be intended. However, as it is currently drafted, there is a risk that this is exactly how these rules would be applied.

These proposals also raise the question of how these rules would affect the standard profits interest. In other words, what would be the threshold for ordinary income treatment where there is no underlying capital interest?

Conclusion

Most multitier partnership investments appear to be safe from the net investment income tax as long as the activity is not passive. However, for those involved in trading in financial instruments or commodities, any activity, whether active or passive, is subject to the net investment income tax regardless of how the investment is structured.

As for carried interests, the broad definition of a specified asset will potentially subject many multitier partnership structures to ordinary income tax rates on their carried interest income. Further, it is unclear how these rules would apply to a traditional “profits interest” when there is no underlying capital interest.